Tesla, Toyota and transition risk

The core premise of climate transition risk is that efforts to green the economy will cause problems for corporations and households, threatening losses for the banks that lend to them.  If private entities are left to their own devices, they will choose to pursue the path they perceive to be the most profitable.  If they are forced to deviate from laissez faire their profitability will be harmed and the risk of default will rise as a consequence.

This premise is clearly sound.

In a very real sense, transition risk is the background radiation of the banking business.  Corporations constantly face changing consumer tastes and political systems with the power – and often the incentive – to abruptly move the regulatory goalposts.  Businesses adapt or die, and successful banks must be skilled at selecting the survivors so that they can outcompete their competitors.

Many in the banking industry seem to believe that the specific problem of climate transition is a new phenomenon.  The implication is that there are no precedents we can call on to better understand and predict the potential cost of accelerated future transition efforts on default likelihood.  Of course this is not true.

I would argue that climate legislation began following the Great Stink of London in 1858.  It proceeded through various clean air acts passed around the world in the 1950s and 1960s, then progressive efforts to tighten the legislation over time with the formation of entities like the US Environmental Protection Agency in the 1970s. 

I apologize for my US/UK/Australian/English language bias.  I’m certain I’ve overlooked important legislation passed earlier by other countries.

These legislative landmarks both reflect and refract the tastes of the populace.  Bold political action does not occur in a vacuum.  Once people get a taste of pollution-free air they tend to like it and are then willing to change their behavior to keep it that way. 

Of course, our collective efforts so far have not been sufficient to achieve climate sustainability.  However, my point is that there are historical precedents that fall squarely under the definition of climate-related transition.  In the wake of these transformations, some companies have risen, and some have fallen.  Some banks have made money in the process, while others have incurred considerable losses.  

If we want to infer the future impact of transition efforts, our best hope is to learn every possible lesson from these earlier experiences.

The Auto Industry

Personal transportation is obviously a major contributor to both urban pollution and global warming.  As such, there has been a considerable amount of legislation and new technology introduced to address tailpipe emissions.  Most countries around the world have, in stages, ushered in legislation that requires manufacturers to produce cleaner vehicles.  Because of the incremental nature of these changes, we have the data necessary to empirically assess the effect of tighter standards on corporate default rates.

I would argue that the history of the US auto industry in the 1970s provides a perfect case study of transition risk at work.  Up to this point, the industry evolved with relatively little concern for the climate pollution spouted by their creations.  In 1970, amendments to the Clean Air Act introduced vehicle emission standards for the first time. 

This had two major effects on the industry.  The first was that it enabled producers like Honda, Toyota, and Nissan – with a history of selling smaller vehicles in the Japanese market – to gain a strong foothold and even dominance in the US.  The second was that it exposed vulnerabilities – especially the lack of production and design flexibility – inherent to the incumbent “Big Three” US producers, especially Chrysler.

You could easily argue that the initial failure of Chrysler, in 1979, was an early example of a major corporate default directly triggered by the climate transition.  Of course, there were other problems at the company, but in an alternative universe with no changes in emission controls, they likely would have skated through the 1970s without their weaknesses being exposed so brutally.

The point is that transition risk is real and there are relevant lessons from history we can draw upon.  Let’s fast forward to see what else we can learn.

A tale of two innovators: Toyota and Tesla

If you look at the range of low-emission vehicles available around the world, two technologies now dominate: hybrids and pure play electric vehicles (EVs).

Hybrid technology was first invented in 1901 but did not go mainstream until Toyota introduced the Prius in 1997. The combination of a traditional internal combustion engine (ICE) with an electric motor, together with technologies like regenerative braking, led to major improvements in vehicle gas mileage.  Toyota’s technology has been mimicked by virtually every major producer, but the Japanese giant remains a key innovator and leading producer.  Variants of these vehicles are now strongly represented in the world’s auto fleet.  In Europe, about 23% of new cars are now hybrids, according to the European Automobile Manufacturers’ Association (Acea).

This group also says that 13% of new vehicles sold in Europe are pure battery electric in nature.  Diffusion of both hybrids and EVs has been slower in the US, with 10% and 7% market penetration, respectively.

EVs have existed for far longer than ICE machines.  Their short range, though, precluded widespread adoption throughout the 20th century.  Tesla’s main contribution has been to dramatically improve the practicality of EVs by fitting them with large, modern batteries capable of providing a useful range.  The blistering speed of their vehicles is another attraction, though this feature has little to do with saving the planet.

Again, while Tesla popularized long-range EVs, other producers have moved fast to replicate their innovations.  Virtually every traditional carmaker – and several new entrants – have started producing vehicles capable of competing with Tesla’s S-3-X-Y offerings.

The two T’s and transition risk

The fact that Tesla’s market capitalization is greater than the aggregate of several (most?) of its competitors is well known.  This remains true despite a recent sharp fall in the Elon Musk-run carmaker’s share price.  We could debate this valuation ad nauseum and even place bets on its future direction if we so fancied.  If you have not read the booming literature provided both by short sellers and fanboys – they nearly always identify as male – I suggest you head down the rabbit hole for a few hours.

The above chart shows the share prices of Toyota and Tesla over the relevant time period.  You can see the monumental rise Tesla investors enjoyed during the pandemic.  If you treat Tesla purely as a carmaker, this increase suggests that the company will grow to dominate the EV space.  Another possible explanation is that investors give considerable credence to Tesla’s claims about the potential of its self-driving technology and the promise of driverless robotaxis.

What’s interesting is that Toyota did not experience a similar valuation jump after it rolled out its game-changing hybrids.  You’ll also notice that while Tesla’s value has roughly halved since its peak, Toyota’s has quietly trended higher over an extended period of time.  Bear in mind that Toyota is the world’s largest seller of personal vehicles – Tesla was 14th in 2023 – so Toyota sells five times as many cars.  While Tesla’s growth has been rapid of late, its sales are starting to sag in 2024, suggesting that EV domination is not a realistic medium-term goal for the company.

So which entity represents the greater credit risk?  Tesla is worth more but its value is far more volatile and may ultimately prove to be illusory.  Toyota is a known entity with a long history and is a dominant player in the automotive industry.  There are significant question marks around Tesla’s performance and whether it will be able to convert the unquestioned hype around its products into stable, long-term profits.  Tesla is rated BBB by S&P while Toyota is four notches higher at A+.

And what about transition risk specifically?  Toyota was criticized for its relatively slow adoption of pure EVs, choosing instead to focus on its bread and butter hybrid technology.  While there is little doubt that electric will dominate new car sales in the 2030s and 2040s, in the meantime hybrid vehicles look like a good way to ease into the transition.  In the past year, US sales of hybrids have been strong while pure EV sales have languished.  The recent surge in Toyota’s share price – a mirror image of Tesla’s decline – suggests that investors are starting to better appreciate Toyota’s careful approach to pure electric.

The question going forward is how Toyota will manage the inevitable demise of its hybrid vehicles and whether Tesla will survive at all.  At the moment, the former’s performance suggests that slow and steady will win the race, even though hybrids are arguably less effective at countering the global warming threat.  

Relatively riskless transition efforts by companies will both cautiously follow, and boldly lead, consumers in the direction of climate salvation.  Toyota originally led, by first introducing smaller cars into the American market and following up with the highly consequential popularization of hybrid technology.   In recent years it has been a follower, realizing that the infrastructure required to enable the widespread adoption of EVs is lagging.

Tesla has also been a great leader, but is its boldness enough for it to achieve ultimate success?  If EV sales plateau or even decline, it’s in real trouble, because unlike Toyota the company has no Plan B.  

Tesla investors will need to show an awful lot of patience if the automaker is to avoid becoming another Chrysler ‘79 – a hapless victim of transition risk.